My first lesson in the power of contagion happened in 1997, when I was based in Seoul. The Asian financial crisis had started midyear in Southeast Asia--first in Thailand, where it was labeled "bahtulism," after Thailand's currency, the baht, and then spreading to Malaysia and Indonesia. From Seoul, half a continent away, the crisis seemed to be very distant. Why would a problem in Thailand extend to wealthier South Korea?
By October, the crisis had done exactly that. South Korea got infected by financial contagion. It took all of us in Seoul a while to wake up to that reality. On the surface, contagion makes no sense. Just because country A falls into a debt crisis doesn't mean countries B, C or G should as well. But that's not how investors think in times of uncertainty. Instead, they look for other potential trouble spots, then try to get out of them.
Bankers realized that, as in Thailand and Indonesia, the private sector in South Korea had unsustainable levels of debt, and they stampeded for the hills. Within weeks, South Korea was nearly emptied of hard currency and went begging for an International Monetary Fund (IMF) bailout.
Europe may be facing a similar contagion effect today. Worries that overindebted Greece could default sent investors scouring for the next ticking debt bomb. The euro zone has quite a selection to choose from: Portugal, Italy, Ireland and Spain, which, along with Greece, form the aptly nicknamed PIIGS. Yields on the sovereign bonds of Portugal and Spain have already risen, a sign that investors believe holding their debt is becoming riskier.
Not even the unprecedented $145 billion European Union--IMF bailout for Greece announced in early May is guaranteed to stop things from getting worse. In South Korea in 1997, the IMF rescue failed to restore shattered investor confidence. To do that took a further show of support for the country from the international community and a firm commitment to reform from the Seoul government.
For Greece, matters aren't all that different. Athens still must prove it can implement the brutal tax hikes, public-sector salary cuts and other budget-reduction measures it promised in return for the aid. With fierce domestic opposition to any austerity plan, investors remain doubtful Greece can uphold its end of the bargain. Nor will they take their wary eyes off the other PIIGS, which also need to undertake painful fiscal reforms to prevent their own Greek-style meltdowns.
And why stop in Europe? Much of the industrialized world is emerging from the Great Recession buried in debt, the result of historical profligacy mixed with the costs of stimulus packages and bank bailouts initiated during the recession. Japan, the U.K. and, let's not forget, the U.S. are each carrying ever larger loads of government debt.
I'm not predicting that the crisis in Greece will envelop the globe like a financial black plague. No investor should equate Greece's problems with those of the U.S. But we're not in normal times. Investors' psyches are plagued by a fragile global recovery and traumatized by memories of the post--Lehman Brothers collapse. There's no way of knowing where contagion will stop once it gets rolling.